Act Fast and Kiss Your Returns Goodbye

On Tuesday, the S&P 500 index lost 2.5%. An index! Of 500 very large companies! Two and a half percent! Yesterday, it lost another 2.5%.

Watching your nest egg slowly bleed is about as much fun as, well, slowly bleeding. But this should be clear: Days like these will happen in your investing career. The protracted slump we've been in since the credit and housing troubles surfaced will happen. Harsh years like we saw in 2001 and 2002 will happen.

Markets slump, stocks drop, you lose money
It's a pattern as inevitable as it is frustrating. And frustration often leads investors to ignore the stock advice that my comrade Tim Hanson and I found will make you rich:

  1. A consistent philosophy.
  2. A sense of perspective.
  3. Daily discipline.

See, while some of this week's losses were significant to the long-term prospects of a business -- Citigroup (NYSE: C  ) comes to mind for its $10 billion loss in the last quarter, its job-cutting strategy, and its dividend slash -- many (most, even) stocks were simply dragged down with the current.

The most dangerous thing you can do in those cases is to lose your sense of perspective. Because once you do that, you'll convince yourself that you need to do something.

While cutting ties with a stock that has fundamentally changed is wise, doing something is trouble, pure and simple. And it reeks of desperation. More often than not, doing something means changing course -- selling losers, chasing winners, or sitting on the sidelines until things aren't as bleak.

Stampede with the stampede
Consider this paradox:

An investor who became unduly discouraged by a market drop and who allowed himself to be stampeded into selling at a poor price was 'perversely transforming his basic advantage into a basic disadvantage.'

That's from Roger Lowenstein's superb biography of Warren Buffett. The quoted section comes from Buffett's teacher, Ben Graham; Graham wrote that in the 1930s.

More recently, in their annual report to fundholders, Vanguard Strategic Equity bosses James Troyer and Joel Dickson spoke to the ills of losing a sense of perspective:

Betting on style requires that you be right twice -- when you initially make the bet and when you remove it. Being wrong on either decision can wreck the return of your portfolio.

Soccer really does explain the world
The next time you experience a down day or portfolio gyration, think about those words of wisdom before jumping from one strategy to another. Or even better: Don't do anything at all. (One good way to handle volatility is to simply not quote your stocks so much.)

In a 2005 study, "Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks," five Israeli professors found that while "the utility-maximizing behavior for goalkeepers is to stay in the goal's center during the kick, in 93.7% of the kicks the goalkeepers chose to jump to their right or left."

In other words, in a high-stress situation, the most efficient decision -- inactivity -- was taken but 6% of the time. The researchers hypothesized that the reason for the discrepancy was "action bias":

According to the norm theory, people have stronger feelings associated with outcomes when they come from abnormal causes. Consequently, because the norm is that goalkeepers jump to one of the sides, the disutility associated with missing a ball might be greater following a non-common behavior (staying in the center) than following normal behavior (jumping to the side).

Next time you find yourself with an itchy trigger finger on a tough market day, remember the plight of the elite soccer goalkeeper.

Inactivity in action
Over the past decade, the market has seen bullish runs and bearish ones; dot-com irrational exuberance; corporate corruption and the resulting legislation; 9/11 and the wake it left; and now a global credit crisis. The market has been more up than down, yet there have been many down days, weeks, and months. But look at how some strong businesses weathered the past 10 years:

Company

Return, Jan. 1998 to Jan. 2008

No. of Down Years

No. of Years Down by 20% or More

Adobe Systems (NASDAQ:ADBE)

740%

2

2

Amazon.com (NASDAQ:AMZN)

1,745%

4

2

Frontier Oil (NYSE:FTO)

2,120%

2

1

Biogen Idec (NASDAQ:BIIB)

894%

2

2

Laboratory Corp. of America (NYSE:LH)

1,626%

3

2

Apple (NASDAQ:AAPL)

5,937%

2

2

Screening and data courtesy of Capital IQ, a division of Standard & Poor's. Returns adjusted for dividends.

Apple, one of the best-performing investments over the trailing 10 years, actually declined by 73% at the beginning of this decade.

The actions you should be taking
This isn't to say you should never sell. It's just that you should be investing with your brain, not your emotions. Without a sense of perspective, you don't have a chance of long-term wealth creation in the market. So make it your resolution today to steel your stomach and change your mindset -- fortunes are made over decades by investing in high-quality companies at good prices.

Of course, you'll also need to find the right businesses on which to hitch your dollars. Our Stock Advisor service has a list of more than 50 recommended companies. We even rank our top five stock ideas for new money now. If you're interested, we offer a free trial with no obligations to subscribe.

Brian Richards owns shares of Vanguard Strategic Equity, but no other securities mentioned in this article. Brian was a goalkeeper on his middle-school soccer team but "action bias" never afflicted him -- neither did "playing time." Biogen Idec, Amazon, and Laboratory Corp. of America are Motley Fool Stock Advisor picks. The Motley Fool has a disclosure policy that roots for Arsenal.


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